Market Sentiment Favors US Dollar

Trouble in the Eurozone is not being eased by murmurs of a shake-up in the Spanish government or rising yields there and in France, and the low sentiment there is strengthening of the U.S. dollar. The trend may not last, however, considering the Congressional super committee tasked with identifying budget cuts has failed to come to a consensus, and the $1.2 trillion in automatic cuts that will result are expected to be a negative blow to the 2012 economy that may have far-reaching implications, since the cuts are back-loaded over a 10-year period. For more on this continue reading the following article from TheStreet.

The recent trend of dollar strength continues Monday morning as developments in the eurozone weigh on sentiment.

The prospect of a change in the Spanish government has done little to calm nerves. Spanish yields, together with other peripheral yields, are higher.

French yields are also higher on news that the recent rise in rates and the growth outlook could be negative for France's credit rating.

As a result, global stocks are markedly lower, with European banking shares down 2.7%. On the data front, Japan's trade balance shifted to a 273.8 billion yen deficit in October from a 300.4 billion yen surplus in September, driven in part by the 3.7% export drop.

Foreign exchange markets this week are likely to be dominated again on two fronts: global growth and policy.

In the U.S., the fiscal super committee faces a deadline of Wednesday, but its rules require that any agreement be made available to committee members two days before, making the effective deadline today.

Headlines over the weekend suggest that the super committee may fail to agree on a measure, resulting in 1.2 trillion worth of automatic spending cuts that begin in fiscal-year 2013.

The cuts would be split between defense and other domestic programs, with most of the cuts back-loaded over a 10-year period.

More worrying in the near term is that without an agreement the path forward for extending the payroll tax cut and emergency unemployment benefits is much less clear, and the risk that those provisions expire at the end of the year increases.

Ultimately, this would feel like a tax increase and looking ahead would likely be a fiscal drag to 2012 economic growth. Against the current backdrop, failure to reach an agreement would likely deal a blow to market sentiment, which for FX would likely be a positive for both the dollar (USD) and yen (JPY) in the near term. A failure of the US to address its debt troubles in the long-run would likely be negative for the USD's reserve status and may in time support further reserve diversification, but we do not think markets are focusing on this aspect yet.

In Europe, concerns about growth are also likely to be on the markets radar screen this week, with the November PMI and German Ifo expected to be the key data reports.

Softer cyclical data are likely to support the notion that the deepening eurozone debt crisis (and resulting financial market stress) is affecting the real economy in the core as well as the embattled eurozone periphery.

The market expects to see the regional composite moderate again in November, with both Germany and France expected to remain below the boom/bust level of 50, indicating that both countries' economies are expected to sink further in the coming months.

Germany's Ifo business climate is likely to paint a similar picture. Indeed, the Bundesbank just cut its German GDP growth forecast to 0.5%-1.0% from 1.8% back in June.

On the policy front, the European Commission is expected to publish a paper on Eurobonds this Wednesday, Nov. 23, while many are interested in today's SMP data from the European Central Bank to see the extent of ECB purchases last week.

Above all, the key drag on sentiment should remain the deterioration in the eurozone economic outlook, resulting in higher funding costs in the periphery, which should weigh on the euro and growth sensitive currencies.

We look for a convincing downside break on the euro-dollar currency pair of the $1.34 level to open the door for a move to the October lows near $1.3146. Resistance is seen around last week's highs around $1.3614 and $1.3641.

In the emerging-market space, markets are still focused on the deteriorating outlook of Eastern European banks amid the intensification of eurozone financial market stress.

Hungary, in particular, remains in a tough situation, with the euro/forint currency pair (EUR/HUF) recently setting a new all-time high at 317.72.

The combination of the negative external risks against the backdrop of deterioration of credit conditions in Europe and weakening domestic environment has led Hungarian policymakers to revisit their stance and return to the International Monetary Fund for financial assistance.

The details of the kind of loans and conditions the IMF will lend will be known later on, but likely disagreements over conditionality may delay the deal beyond January or February.

Nevertheless, the outlook for Hungary is likely to be dominated by the events in Europe, together with what we see are likely ratings downgrades to junk status. Fundamentals in Hungary remain poor regardless of an IMF deal, and we see HUF continuing to underperform as it did in 2008-2009 and September 2011.